1. An upward sloping yield curve
A) is an indication that interest rates are expected to increase.
B) incorporates a liquidity premium.
C) reflects the confounding of the liquidity premium with interest rate expectations.
D) all of the above.
E) none of the above.
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Rationale: One of the problems of the most commonly used explanation of term structure, the expectations hypothesis, is that it is difficult to separate out the liquidity premium from interest rate expectations.
2. The "break-even" interest rate for year n that equates the return on an n-period zero-coupon bond to that of an n-1-period zero-coupon bond rolled over into a one-year bond in year n is defined as
A) the forward rate.
B) the short rate.
C) the yield to maturity.
D) the discount rate.
E) None of the above.
Rationale: The forward rate for year n, fn, is the "break-even" interest rate for year n that equates the return on an n-period zero- coupon bond to that of an n-1-period zero-coupon bond rolled over into a one-year bond in year n.
3. When computing yield to maturity, the implicit reinvestment assumption is that the interest payments are reinvested at the:
A) Coupon rate.
B) Current yield.
C) Yield to maturity at the time of the investment.
D) Prevailing yield to maturity at the time interest payments are received.
E) The average yield to maturity throughout the investment period.
Rationale: In order to earn the yield to maturity quoted at the time of the investment, coupons must be reinvested at that rate.
4. Which one of the following statements is true?
A) The expectations hypothesis indicates a flat yield curve if anticipated future short-term rates exceed the current short-term rate.
B) The basic conclusion of the expectations hypothesis is that the long-term rate is equal to the anticipated long-term rate.
C) The liquidity preference hypothesis indicates that, all other things being equal, longer maturities will have lower yields.
D) The segmentation hypothesis contends that borrows and lenders are constrained to particular segments of the yield curve.
E) None of the above.
Rationale: A flat yield curve indicates expectations of existing rates. Expectations hypothesis states that the forward rate equals the market consensus of expectations of future short interest rates. The reverse of c is true.
5. The concepts of spot and forward rates are most closely associated with which one of the following explanations of the term structure of interest rates.
A) Segmented Market theory
B) Expectations Hypothesis
C) Preferred Habitat Hypothesis
D) Liquidity Premium theory
E) None of the above
Rationale: Only the expectations hypothesis is based on spot and forward rates. A and C assume separate markets for different maturities; liquidity premium assumes higher yields for longer maturities.
6.
| Par Value | $1,000 |
| Time to Maturity | 20 years |
| Coupon | 10% (paid annually) |
| Current Price | $850 |
| Yield to Maturity | 12% |
Given the bond described above, if interest were paid semi-annually (rather than annually), and the bond continued to be priced at $850, the resulting effective annual yield to maturity would be:
A) Less than 12%
B) More than 12%
C) 12%
D) Cannot be determined
E) None of the above
Rationale: FV = 1000, PV = -850, PMT = 50, n = 40, i = 5.9964 (semi-annual); (1.059964)2 - 1 = 12.35%.
7. Interest rates might decline
A) because real interest rates are expected to decline.
B) because the inflation rate is expected to decline.
C) because nominal interest rates are expected to increase.
D) A and B.
E) B and C.
Rationale: The nominal rate is comprised of the real interest rate plus the expected inflation rate.
8. Statistical estimation of the yield curve contains apparent pricing error. These error terms are probably a result of
A) tax effects.
B) call provisions.
C) out of date price quotes.
D) all of the above.
E) none of the above.
Rationale: All of the factors listed can cause what appear to be pricing errors but are actually reflective of inaccurate reporting, differences in investor tax status, and differences in bond indentures.
9. Forward rates ____________ future short rates because ____________.
A) are equal to; they are both extracted from yields to maturity.
B) are equal to; they are perfect forecasts.
C) differ from; they are imperfect forecasts.
D) differ from; forward rates are estimated from dealer quotes while future short rates are extracted from yields to maturity.
E) are equal to; although they are estimated from different sources they both are used by traders to make purchase decisions.
Rationale: Forward rates are the estimates of future short rates extracted from yields to maturity but they are not perfect forecasts because the future cannot be predicted with certainty; therefore they will usually differ.
10. The pure yield curve can be estimated
A) by using zero-coupon bonds.
B) by using coupon bonds if each coupon is treated as a separate "zero."
C) by using corporate bonds with different risk ratings.
D) by estimating liquidity premiums for different maturities.
E) A and B.
Rationale: The pure yield curve is calculated using zero coupon bonds, but coupon bonds may be used if each coupon is treated as a separate "zero."
11. The market segmentation and preferred habitat theories of term structure
A) are identical.
B) vary in that market segmentation is rarely accepted today.
C) vary in that market segmentation maintains that borrowers and lenders will not depart from their preferred maturities and preferred habitat maintains that market participants will depart from preferred maturities if yields on other maturities are attractive enough.
D) A and B.
E) B and C.
Rationale: Borrowers and lenders will depart from their preferred maturity habitats if yields are attractive enough; thus, the market segmentation hypothesis is no longer readily accepted.
12. The yield curve
A) is a graphical depiction of term structure of interest rates.
B) is usually depicted for U. S. Treasuries in order to hold risk constant across maturities and yields.
C) is usually depicted for corporate bonds of different ratings.
D) A and B.
E) A and C.
Rationale: The yield curve (yields vs. maturities, all else equal) is depicted for U. S. Treasuries more frequently than for corporate bonds, as the risk is constant across maturities for Treasuries.
Use the following to answer questions 33-36:
| Year | 1-Year Forward Rate |
| 1 | 5.8% |
| 2 | 6.4% |
| 3 | 7.1% |
| 4 | 7.3% |
| 5 | 7.4% |
13. What should the purchase price of a 2-year zero coupon bond be if it is purchased at the beginning of year 2 and has face value of $1,000?
A) $877.54
B) $888.33
C) $883.32
D) $893.36
E) $871.80
Rationale: $1,000 / [(1.064)(1.071)] = $877.54
14. What would the yield to maturity be on a four-year zero coupon bond purchased today?
A) 5.80%
B) 7.30%
C) 6.65%
D) 7.25%
E) none of the above.
Rationale: [(1.058) (1.064) (1.071) (1.073)]1/4 - 1 = 6.65%
15. Calculate the price at the beginning of year 1 of a 10% annual coupon bond with face value $1,000 and 5 years to maturity.
A) $1,105.47
B) $1,131.91
C) $1,177.89
D) $1,150.01
E) $719.75
Rationale: i = [(1.058) (1.064) (1.071) (1.073) (1.074)]1/5 - 1 = 6.8%; FV = 1000, PMT = 100, n = 5, i = 6.8, PV = $1,131.91
16. What should be the holding period return of a 9% annual coupon bond with face value $1000 and five years to maturity if it is purchased at the beginning of year 1 and sold at the beginning of year 2, assuming that rates do not change.
A) 6.0%
B) 7.1%
C) 6.8%
D) 7.4%
E) none of the above.
Rationale: Using the information in 15.36, P0 = $1,131.91; i = [(1.064) (1.071) (1.073) (1.074)]1/4 - 1 = 7.05%; FV = 1000, PMT = 100, n = 4, i = 7.05, PV = $1,099.81; HPR = (1099.81 - 1131.91 + 100) / 1131.91 = 6%.
17. Given the yield on a 3 year zero-coupon bond is 7.2% and forward rates of 6.1% in year 1 and 6.9% in year 2, what must be the forward rate in year 3?
A) 7.2%
B) 8.6%
C) 6.1%
D) 6.9%
E) none of the above.
Rationale: f3 = (1.072)3 / [(1.061) (1.069)] - 1 = 8.6%
18. Consider two annual coupon bonds, each with two years to maturity. Bond A has a 7% coupon and a price of $1000.62. Bond B has a 10% coupon and sells for $1,055.12. Find the two one-period forward rates that must hold for these bonds.
A) 6.97%, 6.95%
B) 6.95%, 6.95%
C) 6.97%, 6.97%
D) 6.08%, 7.92%
E) 7.00%, 10.00%
Rationale: 1000.62 = d1 X 70 + d2 X 1070;
1055.12 = d1 X 100 + d2 X 1100;
2620.36 = 3000 d2;
d2 = .8735; d1 = .9427; r1 = 6.08%; r2 = 7.92%.
19. An inverted yield curve is one
A) with a hump in the middle.
B) constructed by using convertible bonds.
C) that is relatively flat.
D) that plots the inverse relationship between bond prices and bond yields.
E) that slopes downward.
Rationale: An inverted yield curve occurs when short-term rates are higher than long-term rates.
20. Assuming the forecasts implicit in a yield curve come to pass, an inverted yield curve would be most favorable for
A) short-term borrowers.
B) long-term borrowers.
C) short-term lenders.
D) long-term lenders.
E) nobody - Neither a borrower nor a lender be.
Rationale: Short-term borrowers would face high interest rates. Long-term borrowers would lock in a higher rate than necessary. Short-term lenders would earn a high rate initially, but later would earn lower rates. Long-term lenders would lock in higher interest rates than they could in the future. Note: If lower rates occur later, some of the long-term borrowers may choose to prepay their loans.
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Umeed
MBA 3rd Sem
